Contracts For Difference: Should You Trade CFDs?
What is Contract for Difference?
Contract for difference is a contract to trade the price of a stock without the formal ownership of a stock or share in traditional share trading.
You can go long or sometimes short on CFDs, and can be traded on margin, and interest charges apply on long positions, and paid on short. There are different types of CFD in today's market, including market maker, DMA or Direct Market Access or Exchange CFDs in certain countries.
You can read more about these 3 different types of Contracts for Differences or CFDs here.
But you must know the advantages and disadvantages of CFDs, especially after the global financial crisis or GFC over 2007-2010.
With choosing a CFD broker or provider itself, there are various considerations to take into account when trading CFDs.
This includes the brokerage they charge, the interest, the spread, the CFD market they offer (ie what stocks, indices, commodities and other derivatives thaty offer), the types of accounts, CFD platforms and charting abilities of these trading platforms, the helpfulness of the dealing desk, stability of the company and much more. This is further discussed in this section on how to CFD brokers.
But to the question of trading CFDs, here's what you should know about trading CFDs and their benefits and pitfalls:
CFDs or Contract For Differences Features:
Beware, this is also the pitfall that inexperienced traders can fall into (we'll come to this later).
The leverage enables a trader to have a leveraged float larger than their cash float. So this will magnify their trading returns.
2. Short trading.
Short trading with CFDs cost the same as going long and the interest component is paid to the trader instead of the trader paying it to the provider, and there is no need for a full service provider.
However, in 2008 there has been temporary bans on short selling of shares in several countries around the world including the US, the UK and Australia. Though CFDs are a "derivative product", many providers reduced or stopped for a while the ability to short CFDs as the ban interfered with CFD broker's ability to hedge positions.
Commissions and costs of trading reduce the profitability of trading as it can be a fixed cost, as there is a minimum commission in most cases.
Contract For Difference - Factors To Be Aware Of:
1. The leverage - when misused.
This is a mistake that many traders get into.
During great bull run yeas, many traders used a lot of leverage.
And when the value of their CFDs went up, their available margin increased and they took even more positions. This is all well and good if the stocks keep going up, but wiser traders will be more cautious with their leverage. If the price falls, then you can lose more thatn your cash float.
2. Possible slippage
Slippage is a potential problem in non or low liquid stock CFDs.
If volume of trading is low, then your intended exit price may not occur. So stop losses though present, may result in a lower than expected sell price due to liquidity issues.
The way to prevent slippage is to trade in liquid markets.
Also observe the performance of your market maker to ensure that there exists and trades are performed promptly and with miminal slippage.
3. Hold ups when takeovers occur
When there are stock takeovers or company collapses, your funds may be held up for months until the company is liquidated or taken over.
Such events happen in the real market place and can affect CFDs.
So if you're short a CFD that devalued to zero, you may not be paid the profits of doing do for months. What exactly happens in such situations does depend on each CFD provider as well. Obviously if you're long a stock CFD that went to zero, then this is a losing trade. Hence it comes back to responsible use of margin and leverage.
All trading involves a high risk of financial loss, and the information on this site is for general information purposes only and is not financial advice in any form. Seek your own financial advice before taking any action.
All forms of trading involves risk of financial loss.
Also note that CFD trading is not legally permitted in some countries.
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